Public Pension Reform: Does Mexico Have the Answer?

Mexico may have found a formula for avoiding most of the misfortunes that could arise when individuals invest their own funds. What's the right way to support an aging workforce? And why is it that a concept—life-long security—that should bring comfort to all of us is so distasteful to address in public?

by James Heskett

Summing Up

Judging from responses to the January column, the debate concerning reform of the social security system in the U.S. will take many directions before the question can even be framed adequately. If the responses are an indication, any attempt to encourage a rush to a decision would almost certainly fail for lack of adequate education and reflection.

Responses ranged from those suggesting that the reform should be labeled a tax and approached head-on, to those proposing that it be regarded as an investment program. Typical of the former was that of Blaine Mineman, who said, "My opinion is that the Administration should be candid and recognize that social security is a TAX used to fund a basic retirement benefit—the pension equivalent of food stamps. Higher income retirees should not receive a social security benefit. We need to stop kidding ourselves and face the reality that is needed to bring long-term solvency to the social security program." In contrast to this was the view of Fernando das Neves Gomes, who commented, "We can view the money (contributions to the fund) in two different ways: 1) It is money that I as an investor put in now to collect later in my retirement, or 2) It is money I put in now to pay people who are already retired. I prefer the first view ... ."

There was support for forced savings programs. Bill Bittner said, "[Without one] I am afraid a large portion of the population would find beginning retirement savings in their twenties unfathomable." No one, however, supported individual decision making regarding investments. In Edward Hare's opinion, "The average Joe could get fleeced badly and find that he's still unprepared to finance his Golden Years. Does he then turn back to taxpayers to foot his bills?" As Cesar Franco put it, "Relying on individuals to invest their pension proceeds themselves is a mistake. I help people with their finances...and can tell you the majority of people are not ready for that responsibility." For that reason, he supports some kind of federal government-imposed investment guidelines similar to those in Mexico, whether the money is publicly or privately managed.

Several questioned whether the framing of the challenge that the column posed was even correct. In Bittner's words, the real problem is "where the money that is collected is spent." Jerome Golden even raised the question of whether a new system should provide a defined benefit (as it essentially does now) as opposed to basing individual returns on a defined contribution. As he put it, "The debate around 'private investment accounts' (PIA) as a social security option is the wrong discussion ...Instead of creating the equivalent of mini-401(k) accounts, the focus on social security reform should be on the income side. By utilizing an institutionally-provided defined benefit approach that better integrates investment and annuity elements, the cost of providing lifetime income benefits should be dramatically lower than...under the proposed PIA approach."

These comments raise some questions for us. Given how politically sensitive this matter is, just how different, structurally, can a new U.S. system be from the old? What is the "uniquely American" (as some of you put it) solution to this challenge? What, if anything, should be done to get the country ready for the debate? What do you think?

Original Article

There is little political capital in addressing pension reform. Who wants to engage willingly in an exercise in balancing disappointment and dissatisfaction? And yet, the aging workforces of developed countries around the world have created long-term fiscal challenges that are forcing their governments to address this issue now.

Take the situation in the U.S., for example. We are being told that if 25 percent of the contributions to the social security system can be deposited in private versus public accounts, the transition "cost" (really a fiscal budget deficit) will be up to $2 trillion. Theoretically, the impact of this on pensioners could be substantial. If one accepts often-referenced calculations, the current total return on all social security contributions made to the U.S. government is the equivalent of about 2 percent in benefits returned to individuals. By diverting 25 percent of one's contributions to investments that could yield even as little as 5 percent, the rate of return, on average, would rise to 2.75 percent. It may not sound like much, but a 37.5 percent increase in benefits to the average recipient of social security could look very attractive. Further, it would address a potential shortfall of huge proportions in the government's flow of funds that would begin to be felt sometime in the 2040s.

Great Britain has had roughly a similar government-sponsored system, combining public pensions with something called personal pensions, since the late 1980s. It is projected to result in a 26 percent decline in government pension costs over the long term. But as many as one in five Brits are thought to be at risk of not supplementing their eventual loss of government pension income with adequate returns from their personal pensions. The fear is that they will eventually have to turn to the state anyway for help through various programs that provide a "safety net."

In 1997, Mexico inaugurated a program in which all pension contributions are collected by the State and transferred into individual investment accounts managed by private organizations, called AFORES, registered with the government and required to invest in Mexican government bonds. As of January 1, 2004, AFORES were allowed to begin investing up to 15 percent of fund assets in the Mexican stock market and up to an added 20 percent in foreign securities. This ruling is thought to have helped fuel a 40 percent increase in the value of the stocks on the Mexican Bolsa during 2004. Although start-up costs have been high, returns to the accounts are outpacing inflation, and because there are strict investment guidelines, the hope is that the AFORES program will avoid most of the misfortunes arising from allowing individuals to invest their own funds.

What is the answer to this societal issue, one that will be perceived as doing the least harm to a status quo that is not perceived by most (at least in the U.S.) as being currently painful? What kind of trade-offs should be made between personal responsibility, free enterprise, and selective gain and pain on the one hand, and collective responses and shared gain and pain on the other? Is the British model best for the U.S.? Does Mexico offer a better response? Or is there some other preferred alternative? And why is it that a concept—life-long security—that should bring joy, comfort, and self-satisfaction to all of us should be so distasteful to address in public? What do you think?

Comments

Cesar Franco

Financial Advisor

Relying on individuals to invest their pension proceeds themselves is a mistake. I help people with their finances every day, and can tell you the majority of people are not ready for that responsibility. I see the common mistakes they make with their 401(k)s. People either invest too conservatively or are overexposed to risk. Having individuals do it themselves can also create a wider gap between the rich (the more knowledgeable), and the poor (the less educated or less able to access pertinent information).

Mexico's method might be well suited, however, because everyone would benefit the same; this mirrors our current [U.S.] system. However, I think the program should be managed by the federal branch instead of the state.

Something needs to be done soon to fix this mess. People do not want to talk about it or advocate for change because changing a system that was implemented in the 1930s is a big deal, and to change it and be wrong is a huge responsibility. The definition of insanity is "doing the same thing and expecting different results." Inactivity is not going to solve anything. The U.S. should be on the cutting edge. If the suggested change turns out not to be the best idea, we'll know why and fix it, just like social security. I believe the U.S. should have a pension system that reflects why we are the greatest country (superpower) in the world.

Fernando das Neves Gomes

Principal – Executive Consultant, Behind Vision, Digital Report

I think the best model closest to serving American interests is the Mexican model. What I think: We can view the money in two different ways. 1) It is money that I as an investor can put in now to collect later in my retirement; or 2) It is money I put in now to pay people who are already retired. I prefer the first view, and I think it's the correct one. Following that perspective, I am the person who cares most about the best performance of that money. I would like to see a new platform that would display metrics of the overall investments. I would follow it daily as just one more page of reference in financial news, one new portal.

Jerome Golden

President and CEO, Golden Retirement Resources

The debate around "private investment accounts" (PIA) as a social security option is the wrong discussion. As envisioned, the PIA would accumulate assets with market returns (after investment and administrative costs) and would be available to purchase an "annuity" at retirement (at a time when investment markets may or may not be depressed).

Instead of creating the equivalent of mini-401(k) accounts, the focus on social security reform should be on the income side. By utilizing an institutionally-provided defined benefit approach that better integrates investment and annuity elements, the cost of providing lifetime income benefits should be dramatically lower than the comparable cost under the proposed PIA approach. Our tests suggest an advantage of 200 basis points per year.

On the private side, the pension crisis in certain industries will encourage corporate America to further replace defined benefit pension plans with defined contribution plans. Moving to even a partial and voluntary government substitution of a defined social security benefit with a defined contribution plan, merely adds to the problems that retirees already face with any defined contribution account—converting that account into lifetime retirement income.

We believe that the government could and should set the standard for a low-cost, properly financed and managed, defined benefit system. In so doing, they could, among other things, preserve a source of important, secure, cost-of-living-adjustment-protected lifetime income, and at the same time dramatically reduce the transition costs and the period over which these costs would be covered.

Edward Hare

Retired Director, Strategic Planning, Fortune 300 Manufacturer

I don't think anyone has the "right" answer to life-long security yet. Americans want to believe that someone else will magically pay for what they need in old age. We don't like to talk about it because we know the fiction in our hearts...and don't want to consider or acknowledge old age and infirmity.

My chief worry is that our equity markets are too fraught with corruption to entrust even larger sums of money that will be churned and skimmed by a small minority of "professionals." The average Joe could get fleeced badly and find that he's still unprepared to finance his "Golden Years." Does he then turn back to taxpayers to foot his bills?

Anonymous

Very few employees have sufficient knowledge of investments to make sound decisions on investing their future retirement funds. If they were to manage their own retirement funds, the majority would not take any risks to obtain returns sufficient to outpace inflation.

Even with matching contributions towards deferred compensation plans, we have 20 percent of our employees who don't participate in this program.

I think Mexico's approach is much more viable because experts make the investment decisions. In the U.S., we do not educate our citizens in public school about investments. A program such as President Bush is proposing for social security requires that investment education be added to the public school curriculum.

Blaine Mineman

Director, Pensions, Ispat Inland, Inc.

The U.S. administration may realize some "political capital" from younger workers who may utilize the social security separate accounts. However, I think the introduction of separate accounts further obviates the real nature of this program. My opinion is that the administration should be candid and recognize that social security is a TAX used to fund a basic retirement benefit—the pension equivalent of food stamps. Higher income retirees should not receive a social security benefit. We need to stop kidding ourselves and face the reality that is needed to bring long-term solvency to the social security program.

Anonymous

While "pay as you go" pensions are sensitive to demographics, funded pensions are sensitive to financial markets. A diversified system has both. Individual accounts just disturb diversification, thus increase risk. A demographic reserve as undertaken in France (Fonds de Reserve) is politically and financially impossible in the U.S., where the government deficit is already extreme. The second best solution, then, is a reformed system of private occupational pensions by sector, like the NHS system in Britain or the sector funds in the Netherlands. It should be reformed because government guarantees invite moral hazard and should be replaced by strict government oversight, and because DC pensions like 401k leave people painfully underinsured.

Anonymous

You have posed the question in an unrealistic manner. It is extremely unlikely that personal accounts would be offered unless linked to a larger reform package likely to include a change from wage to price indexing of earnings histories in the benefit formula. This would reduce benefits by more than 40 percent in itself by 2075, so a personal account would not offer a net increase in benefits, but rather the potential to make the net loss from current formulas somewhat less. A pure carve out without the other benefit reductions would have fiscal costs beyond the estimate cited.

Francine McKenna

President, McKenna Partners LLC

It warms my heart to see Mexico used as an example to the world for something. The strategy that Mexico has followed will be very beneficial for those workers covered by a pension plan. However, in Mexico this is a much, much smaller percentage of workers than in the U.S. And even in the U.S., many are losing the type of pension benefits that their parents and grandparents enjoyed after many years of work. Most employers in the U.S., other than the federal government, have dropped defined benefit plans for 401k and other self-savings plans. Many who work will never have anything other than social security unless they save on their own. And many who thought they would get a healthy pension will be cheated, as failing companies shirk their obligations and pawn them off to the Pension Benefit Guaranty Corporation (PBGC). One only has to look at the headlines to see the crisis in funding these obligations looming on the horizon.

Mexico as well as the U.S. needs to find ways to raise employment, especially in above minimum wage-paying jobs, to more of the workforce. In Mexico, this may someday discourage Mexican workers from thinking the grass is greener on the other side of the border and allow them to save more for tomorrow, rather than living from day to day. In the U.S., this may mean the reduction in the numbers of the working poor and an increase in their confidence and self-respect, as well as their personal savings. Let's address first things first, as so many here and in Mexico have suffered during the last four years under the first president since Herbert Hoover to oversee a net loss in jobs during his administration.

Bill Bittner

President, BWH Consulting

We see time and time again how impulsive humans can be. I am afraid a large portion of the population would find starting retirement savings in their twenties unfathomable. Only by having a "forced savings program" will many individuals have the discipline to begin their retirement savings early on. The problem with today's system is not the collection mechanism, but where the money that is collected is spent. Instead of using it for a "pay as you go" benefit package to current retirees, it must be put into an investment program that yields future payoffs.